Wallstreet your Real Estate-Post #2
Rule #1: BUYING REAL ESTATE WITH YOUR BACK TO THE SHEEP
Avoiding the Heard Mentality
My favorite visual of the herd mentality is the cartoon pack of lemmings following each other off a cliff. The lemmings in the front can’t see what’s ahead of them and are leading the followers confidently in the wrong direction. The followers can’t see anything so they’re just along for the ride. They’re all headed for certain disaster. In finance, investors following the crowd can lead to massive market rallies or sell-offs without sound justification for either. In real estate, investors following the herd can buy properties they can’t support through lean years later leading to short sales and foreclosures.
This year, the GameStop stock rally showed how social media can influence the herd to buy stock and start a rally that has little basis in the stocks’ fundamentals. In the case of GameStop, a small group discovered that hedge funds were shorting the stock and betting on it going lower. This small group used social media to encourage a massive group to buy shares of stock in Game Stop to increase values as revenge against the hedge fund short sellers. This, in turn, caused more people to become interested in the stock market but it’s anyone’s best guess on how educated those newcomers will become in their purchases. They could do really well or they could follow the social media frenzy right off a financial cliff.
Harrison Reinisch of iNews said it best, “I think it’s very much a double-edged sword, on the one hand, the stock market is a great tool for making money, but only if you are smart about it. I’m not sure people who got into stocks because of GameStop are going to be very smart about it. GameStop was a very bad stock before, and was a dying business, and had a poor brand reputation and it would be very bad if people who have never invested in the stock market and don’t know much about it are buying bad stocks and guessing which are going to go up is going to make them lose a lot of money.” The bottom line is that investing in any asset, whether it’s stock or real estate, requires an in depth understanding of the fundamentals and a willingness to know when to follow and when to buck trends based on that knowledge.
In real estate it’s critical to understand the various asset classes and know which sectors of the market are overheated. Right now, one of the hottest concepts in residential real estate is nightly rentals. Almost everyone in any market near a resort or major metropolitan area wants the ability to do nightly rentals or “Airbnb” their property. Many people think this will magically make the most out of their investment without taking into consideration the costs of managing a nightly rental property versus a long-term rental property. Further, they completely ignore the other asset classes of rentals such as industrial/warehouse, retail, hotel, office, multifamily, and more. Finally, they forget that second homes are often the first to drop in value when the market is faced with a correction.
Investors can do well even in an overheated sector of the market, but they need to know if they can afford to ride through any downturn. A nightly rental property, bought for the right price and for the right reasons, can be very lucrative. In many markets these properties have moved from ‘very lucrative’ into ‘will offset some of your costs so you can enjoy your second home’. There is no problem with offsetting costs while loving your second home, if that’s your goal and if you can afford it. Just don’t buy a nightly rental property thinking it’s going to be firmly in “very lucrative” territory when the fundamentals are showing you that it ‘may’ offset costs and ‘could’ go up in value over time. It could also go down in value over time and your costs could go up.
The popularity of nightly rentals means that this sector of the market in many markets is overvalued so it may be faced with a correction or it may not generate the kind of cash flow you need to ride out a downturn. The last thing any investor wants is to be forced to sell in a declining market, or worse, lose their property to the bank. Having the discipline to understand and analyze all the asset classes from residential to commercial to industrial to land, is key to finding a sector of the market that isn’t overheated. Just because residential rentals feel comfortable since everyone has likely rented a residence in their lifetime or knows someone who has, doesn’t necessarily mean that’s the sector in which you should invest.
In addition to understanding the type of real estate you want to buy, it’s important to understand where you’re buying and why. Instead of following the herd, who is buying in the hot new area, you want to study areas that suit your asset class. The best way to do this is to understand supply and demand for those areas and how that serves your specific asset class. For example, if you’re buying a multifamily, is it near a college or place where young people are flocking? Are there a lot of other multifamilies in the area or the ability to build more? Scarcity of rentals and a growing population means fewer vacancies and rising rents. If you’re buying retail, what are the growth projections for the population in that area and what’s the competition for more retail coming into that location? Is there growing demand for the type of retail that might occupy your space or is it declining? There are so many factors to consider that have nothing to do with where the herd is buying in the next hot new neighborhood.
I know you’ve been watching too much reality TV and you’re dying to tell me that trendy fix and flips only make money in the hot neighborhoods and I agree – if you can find one that’s not overpriced and subject to market volatility. You can buy in a hot market but those are often overvalued or suffer severe downturns when people have spent beyond their means. When you’re buying something to sell quickly, you don’t have time to wait for an up-and-coming area to become popular. If you’re following a popular, risky trend like fixing and flipping, it’s a good idea to hedge that risk with a blue-chip location when you can. Like a white button-down shirt, a blue-chip location is an area that is solidly popular without being ‘hot’. One of the best places for your fix and flip is the blue-chip location. It’s the old ‘worst house in the best neighborhood’ concept. If you can’t find anything in a blue-chip neighborhood then try adjacent areas. If your target audience is families, see if you can find areas are in the same school district as the blue-chip locations. Buying a risky, overheated investment class in a solid blue-chip location means that you can always find tenants if the market tanks so you’re hedging that risk. It also means that you’ll likely find buyers even if the neighboring hot market suffers volatility. Bottom line is that if you follow the herd by investing in a hot asset class, it’s a safer bet if your location doesn’t do the same.
There are a lot of investors who have stumbled into success in the real estate market by blindly following others. Following the herd this way can lead you in a positive direction, but it can also lead you off a cliff. It’s much better to be purposeful and have a strategy. You need to know exactly why you’re buying a certain property and how it fits your portfolio and your goals. A young couple with no children can likely manage a property that needs fixing up whereas a family with toddlers cannot. A retiree might enjoy getting to know people by self-managing a nightly rental, where a busy professional will bristle at those frequent interactions. You don’t want to buy something because everyone else is doing it. Your needs are specific to your time and place in life, not anyone else’s. At the same time, you don’t want to stand on the sidelines and do nothing. In the next blog post, we’ll examine Rule #2: Make an Informed Decision and Move Forward. In that post, I’ll show you how to evaluate your purchase from a financial and personal perspective, so you know exactly what to buy based on your goals.